Middle Market Supply Chain Finance – The Next Frontier?

The constant whine I hear at Conferences, whether it is SWIFT’s Sibos, or the Bankers Association of Finance and Trade or the Commercial Finance Association, is how much loan spreads have thinned for factors and banks lending for reverse factoring better known as supply chain finance. In fact, it seems price is the only true criteria to compete and everyone competes on a “I’ll Beat That Price” strategy.

Pricing for Approved Trade Payable Finance / Reverse Factoring programs in particular do not have the greatest economics. Take an investment grade client, and banks will run programs at Libor + a small spread. The banks must pay a liquidity premium to the bank's treasury for the use of cash, then you pay for the platform costs (let's say all-in this is 45 bps). So the bank makes a very small profit on the credit risk.

So for the bankers competing for Reverse Factoring deals for the Global 2000 investment or near investment grade companies, the next best thing is to offer programs to the Middle Market. This is not as easy as it sounds. I examined this before in a prior post, see Will Trade Payable Finance programs move downstream? To summarize that post, Basel III capital rules make the cost of capital expensive for non investment grade corporates. SCF is an unsecured loan to the buyer, and banks do not want to build up a portfolio of non secured loans to non investment grade middle market companies.

As one Global Trade banker described to me, the reality is when you work with the middle market, you first have to compete on credit internally with other product groups so you can carve out enough to offer supply chain finance. Next, a middle market company may only have two or three suppliers which you can offer the finance, so the scale is not there.

Despite those challenges, what makes these deals at least somewhat attractive is the spreads are much greater given the risks involved and you don’t need fancy platforms to do these deals.

To keep the costs of these programs down, one bank is looking at using discounted trade drafts to eliminate Receivable Purchase Agreements with suppliers, which also tie you to UCC filings. Or you can make yourself the paying agent – you pay invoices at a discount and the middle market corporate would pay you when the invoices would mature. This is unattractive to large corporations, as there is a potential to recharacterize the debt on its books, but the mid market may not be as concerned.

While this may not be a new Gold Rush, there are certainly opportunities here. The trick is finding the industry verticals where this model will work.

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First Voice

David, good points here on the middle market. I think Middle Market SCF will be implemented and funded differently than Large Corporate, investment grade SCF, primarily for the reasons you cited. While some SCF vendors offering the innovations you mentioned (e.g. using electronic time drafts) currently enjoy a regulatory-based barrier to entry, the SCF market as a whole would benefit by the federal government lightening the regulatory burden for SMEs, specifically with respect to KYC.